In the following question, you will trace through the effects of an unexpected decrease in the demand for money in both the short run and the long run.

(a) Using the IS-LM framework, explain how the decreased demand for money would affect national income and interest rates. (Hint: Recall the the LM curve shows combinations of r and Y that result in market clearing in the money market.) What are you assuming here? (Hint: See next question.) How does the change in demand affect investment?

(b) The above analysis is not complete. To fully account for the effects of a decreased demand for money in the short run, we also need to know how the change affects the price level. Using aggregate supply-aggregate demand model, show how the policy affects national income and the price level in the short run. Return to your IS-LM diagram in part (a) and use this new information to update the diagram. How does the effect on investment and national income compare to that from part (a)?

(c) Using the AS-AD framework, explain how the economy adjusts to the change in the demand for money in the long run. Return to the IS-LM framework and explain how the real interest rate and investment respond to the policy in the long run.